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Copyright © 2006 McGraw Hill Ryerson Limited17-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition
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Copyright © 2006 McGraw Hill Ryerson Limited17-2 Chapter 17 Financial Statement Analysis Financial Ratios The DuPont System Analysis of the Statement of Cash Flows Using Financial Ratios Measuring Company Performance The Role of Financial Ratios
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Copyright © 2006 McGraw Hill Ryerson Limited17-3 Financial Ratios Introduction This chapter will describe: 1. Leverage ratios – show how heavily a company is in debt. 2. Liquidity ratios – measure how easily a firm can lay its hands on cash. 3. Efficiency or Turnover Ratios – measure how productively a firm is using its assets. 4. Profitability Ratios – measure the firm’s return on its investments.
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Copyright © 2006 McGraw Hill Ryerson Limited17-4 Financial Ratios Leverage Ratios Leverage ratios show how much financial leverage a firm is carrying. Financial leverage adds risk to the firm.
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Copyright © 2006 McGraw Hill Ryerson Limited17-5 LT Debt + Value of Leases Financial Ratios Leverage Ratios Long Term Debt Ratio = LT Debt + Value of Leases + Equity LT Debt + Value of Leases Debt-Equity Ratio = Equity Total Liabilities Total Debt Ratio = Total Assets
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Copyright © 2006 McGraw Hill Ryerson Limited17-6 EBIT Financial Ratios Leverage Ratios Times Interest Earned (TIE) = Interest Payments EBIT + Depreciation & Amortization Cash Coverage Ratio = Interest Payments EBIT + Depreciation & Amortization Fixed Charge Coverage Ratio = Interest Pymts+(Current Debt Repymt+Current Lease Obligations) (1 - Tax Rate)
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Copyright © 2006 McGraw Hill Ryerson Limited17-7 Financial Ratios Liquidity Ratios Liquidity Ratios measure how much of the company’s assets are liquid. Liquid refers to an asset which can be converted to cash quickly and at low cost.
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Copyright © 2006 McGraw Hill Ryerson Limited17-8 Current Assets – Current Liabilities Financial Ratios Liquidity Ratios Net Working Capital = Net Working Capital Net Working Capital as a % of Total Assets Total Assets =
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Copyright © 2006 McGraw Hill Ryerson Limited17-9 Financial Ratios Liquidity Ratios Current Assets Current Ratio = Current Liabilities Cash + Marketable Securities + Receivables Quick Ratio = Current Liabilities
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Copyright © 2006 McGraw Hill Ryerson Limited17-10 Financial Ratios Efficiency Ratios Sales Asset Turnover Ratio Average Total Assets Sales Fixed Asset Turnover Ratio = Average Fixed Assets =
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Copyright © 2006 McGraw Hill Ryerson Limited17-11 Financial Ratios Efficiency Ratios Average Receivables Average Collection Period Average Daily Sales Cost of Goods Sold Inventory Turnover Ratio = Average Inventory = Inventory Days’ Sales in Inventories = Cost of Goods Sold/365
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Copyright © 2006 McGraw Hill Ryerson Limited17-12 Financial Ratios Profitability Ratios One group, called profit margins, look at profits or earnings as a fraction of sales. The other group, called return ratios, measure profits earned as a fraction of the assets used.
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Copyright © 2006 McGraw Hill Ryerson Limited17-13 Financial Ratios Profitability Ratios – Profit Margins Sales – Cost of Goods Sold Gross Profit Margin Sales EBIT – Taxes Operating Profit Margin = Sales = Net Income Net Profit Margin = Sales Net Income + Interest Sales or
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Copyright © 2006 McGraw Hill Ryerson Limited17-14 Financial Ratios Profitability Ratios – Return Ratios Net Income + Interest Return on Assets (ROA) Average Total Assets = Return on Equity = Net Income Average Equity
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Copyright © 2006 McGraw Hill Ryerson Limited17-15 Earnings Financial Ratios Profitability Ratios Dividends Payout Ratio Earnings = Plowback Ratio = Earnings - Dividends 1 – Payout Ratio = Earnings - Dividends Growth in Equity from Plowback Earnings = = Plowback x ROE
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Copyright © 2006 McGraw Hill Ryerson Limited17-16 The DuPont System DuPont System - ROA Some profitability and efficiency measures can be linked in useful ways. Net Income + Interest ROA = Assets Sales = Assets Asset TurnoverProfit Margin Net Income + Interest Sales x
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Copyright © 2006 McGraw Hill Ryerson Limited17-17 The DuPont System DuPont System - ROE Net Income ROE = Equity Sales = Assets Asset Turnover Profit Margin Net Income+Interest Sales Assets Equity Net Income Net Income+Interest Debt Burden Leverage
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Copyright © 2006 McGraw Hill Ryerson Limited17-18 Analysis of the Statement of Cash Flows Analysis of the Statement of Cash Flows can tell you a lot about the financial health of a firm. By contrast, the Income Statement gives a better sense of the long-run profitability of the firm.
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Copyright © 2006 McGraw Hill Ryerson Limited17-19 Using Financial Ratios Choosing a Benchmark Once financial ratios have been calculated for a firm, they need to be compared to a benchmark. The benchmark could be: The firm’s performance in prior years. Another firm’s performance.
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Copyright © 2006 McGraw Hill Ryerson Limited17-20 Using Financial Ratios Financial Ratios for Selected Industry Groups, 2004
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Copyright © 2006 McGraw Hill Ryerson Limited17-21 Measuring Company Performance MVA and EVA Market Value Added is the difference between the market value of a firm’s equity and its book value. Economic Value Added (EVA or Residual Income) measures the net profit of a firm after deducting the cost of the capital employed.
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Copyright © 2006 McGraw Hill Ryerson Limited17-22 Measuring Company Performance EVA EVA or residual income is a better measure of company performance than accounting profits. EVA recognizes that companies need to cover their cost of capital before they can add value. Residual income = After-tax operating profit - cost of capital x invested capital
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Copyright © 2006 McGraw Hill Ryerson Limited17-23 The Role of Financial Ratios Helping Financial Managers Make Decisions Ratios can help you understand, and improve, your company’s financial health by making sure that its leverage, liquidity, efficiency and profitability are kept at optimal levels.
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Copyright © 2006 McGraw Hill Ryerson Limited17-24 Summary of Chapter 17 As a financial manager, you will be responsible for analyzing your company’s financial statements. You will be looking at its income statement, balance sheet and statement of cash flows. You will use financial ratios to summarize the firm’s leverage, liquidity, profitability and efficiency.
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Copyright © 2006 McGraw Hill Ryerson Limited17-25 Summary of Chapter 17 The DuPont System provides a useful way to link ratios to explain the firm’s return on assets and equity. ROE is a function of the firm’s leverage ratio, asset turnover, profit margin and debt burden. ROA is a function of asset turnover and profit margin.
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Copyright © 2006 McGraw Hill Ryerson Limited17-26 Summary of Chapter 17 Financial ratios need a benchmark for comparison. You can compare ratios with the company’s ratios in prior years and/or with the ratios of other firms in the same business. Other measures, such as Market Value Added (MVA) and Economic Value Added (EVA) are available to help you assess a firm’s performance.
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